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QE3: When? Or If?

The Fed may hold off on another round of quantitative easing given healthier bank lending.

The Federal Reserve’s Open Market Committee (FOMC) has left the outlook for additional quantitative easing ambiguous. The summary from the most recent meeting of Fed policy makers expresses confidence that inflation will remain contained and concern over sluggish economic growth, unemployment and the threat of “global financial strains.” The FOMC promises, in response, to keep short-term interest rates low, with the target federal funds rate between 0 and 25 basis points into late 2014. It also promises to continue through year-end “Operation Twist,” in which it buys longer-term Treasury bonds, to sell nothing from its now-extensive portfolio of mortgage-backed securities and even to reinvest any interest and principal payments it receives. But on the crucial issue, the one that weighs on Wall Street’s collective mind, of a third quantitative easing—QE3 in the Street’s jargon—the Fed remains coy and promises only to respond to the flow of economic and financial information as needed.

It is apparent from this lack of commitment that the Fed remains unsure whether the economy needs another quantitative easing now, or, for that matter, ever. The reasons for this ambiguity, frustrating as it may be for Wall Street’s traders, are nonetheless plain in the policy criteria outlined some time ago by Fed Chairman Ben Bernanke. Because inflation seems well contained for the time being, Bernanke identified two areas as policy cues: one is the jobs market, as a test of whether the economy is making acceptable progress, and the other is bank lending, to judge whether past monetary easing is reaching the economy. The inconclusive mix of evidence on these fronts explains the Fed’s coy attitude. How events in these areas unfold will determine when and, contrary to the common belief on Wall Street, even if the FOMC will go forward with a QE3.

Of course, some have argued that the Fed should simply go ahead, that a quantitative easing now would offer insurance against future cyclical weakness. This line of reasoning is especially popular among Wall Streeters, who are hungry for still more liquidity, regardless of the economy’s needs. But the Fed has broader concerns and is understandably wary. From a policy maker’s point of view, there is as much risk as insurance in such an approach. They know that quantitative easing and other monetary stimuli have built up a huge pool of unused financial liquidity. After all, almost 95% of bank reserves stand in excess of what banks need to back existing loans and deposits. This pool of idle liquidity carries a huge potential to create asset bubbles and ultimately, perhaps, accelerating inflation. Policy makers will not lightly add to that potential. What is more, many at the Fed ask what good more liquidity will do when there already is such a huge unused pool.

At the same time, the jobs picture which the Fed chairman cited as one arbiter of policy leaves questions about the need for more Fed action. The labor market is far from strong, but according to Bernanke, the Fed looks not for a fully healed market, which policy makers know may be years away, but for substantive progress. On that score, the crucial matter is jobs growth and, to a lesser extent, any increase in hours worked. The hours would tell the Fed to wait on further stimulus. Average hours have risen from 33 a week in 2009 to more than 34.5 most recently. The data on jobs growth are less clear. The July report that payrolls expanded by more than 160,000 cuts two ways. As an acceleration from the extremely disappointing growth over the previous three months, it militates against a rush to ease further. The still historically slow pace of expansion—inadequate, in fact, even to keep up with the growth of the labor force—puts the Fed on notice that the battle to secure an economic recovery is far from won.

The pattern of bank lending argues more strongly against the need for more easing. To be sure, banks are going cautiously. They still resist lending in real estate, where credit for commercial and residential ventures, including home mortgages, has dropped all year, a decline that even accelerated in June, though spotty data for July suggest stability. But then even the optimists at the Fed had little expectation of a near-term pickup in this kind of lending.

More significant is the increase in commercial and industrial loans, which have risen at an annual rate of better than 11% year-to-date. This surge, along with modest growth in consumer loans, has lifted all bank lending at better than a 4% annual rate so far this year. From the Fed’s point of view, this flow surely indicates that past monetary ease, that pool of unused reserves, is at last flowing toward real economic uses. The increase in lending hardly means that the Fed has accomplished its cyclical mission, but it does provide a reason to hesitate before making still another grand gesture, however much Wall Street wants it.

So both to accommodate its own perceptions of risk and reflect the mix of evidence in its own policy criteria, the Fed has taken a wait-and-see approach to QE3. Washington’s fiscal problem gives policy makers yet another reason to hold back for the time being. Chairman Bernanke has warned Congress of what he called the “fiscal cliff” of tax hikes and spending restraint scheduled for the new year unless legislators act to stop them. Given the economy’s present ambiguous state, he and other monetary policy makers may want to hold a third round of dramatic ease in reserve on the chance that Congress fails to act and the economy faces what could be severe fiscal restraint.

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